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Friday, June 28, 2013

Is Liquidity Drying Up for World Markets?

There's an interesting fundamental change that's been taking shape in the financial landscape recently. In the U.S., QE-Infinity is still flowing strong, despite talk of tapering. The Bank of Japan is also still fueling the liquidity picture. However, there are some other major players working at cross-currents to the Fed and BoJ's liquidity.

Many investors are probably convinced that the recent market shake-up was simply the result of Bernanke's talk of "tapering" the QE program -- after all, that's what the media largely reported. But the reality runs far deeper than that, and is an order of magnitude more serious. For better or for worse, the U.S. financial system no longer exists in a vacuum, and world markets have reached the point where virtually everything is interconnected. And what's going on overseas is starting to shake things up here.

The world's four largest central banks are: (of course, our very own, let's have a big Las Vegas welcome for) the Federal Reserve, the European Central Bank (ECB), the Bank of Japan (BoJ), and the People's Bank of China (PBoC). The first three (Fed, ECB, and BoJ), as well as the BoE (Bank of England), are all deeply intertwined in the sense of liquidity, since they all deal with the same institutions and dealers, if not always directly, then through counterparty. In fact, fourteen of the Fed's twenty-one primary dealers are located in other countries, with only seven being US-based. It's become one great big happy Universal Liquidity Pool party, and the actions of one nation's central bank no longer simply impact that particular nation.

The PBoC isn't fully integrated into the world financial machine yet, but their actions still impact the world financial system because many of the institutions they service are big players on the world stage. So while they're not quite swimming in this pool and playing "Marco Polo" with Bernanke, the way Western central banks are, they're still very much a presence at the pool party.

And they're not following the script.

While Bernanke keeps dumping fresh water into the pool, and the BoJ is doing the same, the PBoC has tightened policy and aims to force institutions to deleverage, thereby draining the pool. And while the Fed and ECB bail/bailed out every bank they can get their hands on, the PBoC has decided it's had enough. This means the institutions it services are faced with trillions in bad debt, which requires them to sell whatever liquid assets they can in order to raise cash. Much of these liquid assets are in the form of U.S. Treasuries, equities, precious metals, etc..

Many have speculated, myself included, that the final endgame to the massive bubble unwind would be forced liquidation, and it seems we're now beginning to see some cracks appearing in the foundation. The problem in a massively leveraged financial system, such as ours, is that when enough selling occurs and drives down prices, that action creates margin calls for other leveraged players, which then requires them to sell assets as well. This creates more margin calls for still other players, which then requires more selling -- etc. ad infinitum. It can snowball and feed on itself rapidly, ultimately becoming an unruly beast which consumes everything in its path, not unlike John Goodman.

A week ago, the PBoC flat out refused to do reverse repos, thus stopping the flow of cash. Traders and institutions in China panicked, and we saw the results of that action almost immediately, as forced deleveraging hit the marketplace and spread to US stocks and treasuries. Below is quoted from a piece published by Reuters on June 19:

"The central bank appears to be determined to force banks and other financial institutions, such as funds, brokerages and asset managers, to de-leverage," said a trader at a major Chinese state-owned bank in Shanghai. "That hardline stance suits the recent government policy of clamping down on non-essential businesses by financial institutions, such as shadow banking, wealth management, trustoperations and even arbitrage."

Panic prevails in some parts of the money markets, in particular among some small financial institutions, which have conducted lots of leverage businesses, traders said.

According to some reports, the PBoC later relented somewhat and began providing targeted liquidity. Markets stabilized.

Compounding the liquidity situation is what's going in Europe. When the ECB gave out loans via LTRO, it also forced loans on institutions which didn't need or want those loans. The theory was that forcing everyone to take LTRO loans created a "cover up" so that no one could figure out which banks were in truly bad shape, and which banks were just in bad shape. Many of those institutions put a portion of the LTRO money into US Treasuries, which drove yields to record lows in the summer of 2012.

While LTRO was a three-year loan plan, it provided an option for banks to repay those loans after a year, and many of the banks who didn't originally want those loans are now paying them back -- by selling the Treasuries they purchased a year ago. And as that carry trade unwinds, the Treasury market is coming under pressure.

Below is a chart of the 30 year bond, which looks to be in bad shape:

The LTRO situation is deflationary, since that money is now being pulled away the market and vanishing back into the ether from whence it came. And of course, falling treasury prices also have the potential to create further margin calls and leveraging issues.

Precious metals are continuing to come under pressure as well -- in fact, in the overnight Comex session last night, gold reached the upper edge of my long-standing target from April 17 (1080-1180). This may also lead to further forced liquidations.

So now we have a situation where the Fed and BoJ are furiously pumping liquidity, and the PBoC and ECB (as well as the BoE) are effectively draining it. The machine is complicated and there are a lot of moving parts these days, and the impact is global. As the old saying goes: This is not your father's market.

Unless the ECB and PBoC loosen up again, the easy money bull leg is almost certainly over. What's always amazing to me is how this move was (yet again) telegraphed by the charts in advance, and it became instantly apparent that there was some type of trouble on the horizon. I'm still not certain if the entire bull market is over, though. I've been long-term bullish since the first trading day of the year, but recently I've moved the odds of a long-term top up to 50%, and I'm now equally split on the idea of one more leg up, or the top being in. Given the indicator readings at the peak, we'd normally expect to see another leg up. But both the long-term charts and the current decline are fuzzy enough to allow either option. That question is simply going to have to be worked out heading forward.

On the hourly chart, I'm inclined to believe that the current rally either peaked in yesterday's session, or will do so after a marginal new high. I also believe the market will feel obligated to test the noted rising trend line, which currently crosses the 1565-70 zone (and rising).

The hourly trend line chart may help provide clues. It would seem a shame for the market to have come this far without filling the gap in the mid 1620's.

The one-minute chart shows the rally decelerating, which is one of the reasons I believe that a peak has either been reached or is nearby.

In conclusion, the liquidity picture for the world has recently shifted in the bears' favor, and as long as that situation remains, it's likely that volatility will continue. I'm still inclined to believe that the intermediate picture suggests a new low in store before we can start to consider the idea of a meaningful bottom, but that's a very close call given the ambiguous nature of the wave form. I remain evenly split on the long-term odds of a significant top. Near-term, I believe the rally has peaked, or is quite close to doing so. Trade safe.

Note: Much of the credit for the research on central bank policy goes to Lee Adler of the Wall Street Examiner, please visit his excellent site here.

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